What is the role of the financial system in an economy?
One of the important roles of a financial system is to create a conducive financial environment which encourages efficient financial intermediation and bridge the gap between depositors, lenders and the borrowers. In its simplest terms, banks mobilize money from savers and make loans, at risk to the borrowers, for a profit. In this way banks help mobilize the savings of a nation for productive investments and use in the economy.

What is the role of the Royal Monetary Authority of Bhutan (RMA) with regard to the banking/financial system?
From the Regulatory and Supervisory perspective, the Financial Institutions Act of Bhutan 1992 has empowered the RMA to promulgate sound banking and financial policies within the economy. These activities would include issuing of licenses for financial services, prescribe and implement appropriate prudential regulations and guidelines within the framework of which the financial institutions will have to operate, and see to their compliance through continuous off-site surveillance system and frequent on-site examinations. As the supervisory authority, it is the responsibility of the RMA to monitor how the financial institutions manage their risks and to promote a sound and efficient financial system within the country. To summarize the above, the health and financial performance of both banks and non-bank financial institutions are assessed from time -to-time by the RMA. Such assessments are being evaluated based on capital adequacy, asset quality, management competency and professionalism, profitability, liquidity management, and internal controls and systems. Because of their important role in the economy, banks and NBFIs have to be regulated to ensure they are prudently managed.

Why do banks and NBFIs still fail despite regulation and supervision?
Banks and NBFIs make profit by taking calculated financial risks. Among the many types of risks that the financial institutions have to manage are credit risk and liquidity risk. Credit risk is a common cause of problems because the liabilities of financial institutions are largely certain in value but the assets are uncertain in value. In other words, the financial institutions must still repay the full amount of deposit liabilities/liabilities even though the loans made by the financial institutions are those same funds, which are not repaid by the borrowers. With the margin between borrowed and lent funds often being just a few percentage points, it should be clear that just a few bad loans that are not repaid will wipe out the profits made on many loans. For this reason, banks and NBFIs are required to hold a buffer of capital so that depositor funds are kept intact even if there are unexpected losses. Unfortunately, it can happen that unforeseen events result in a spate of bad loans which can wipe out the capital of a bank.
The most common underlying cause for bank failure is actually poor management. For instance, if the credit granting and debt collection processes are not extremely well managed, a bank is almost certain to feel the effects thereof in its profitability and eventually its capital adequacy in the very near future or sometime at a later stage.Despite regulation and supervision, financial institutions do fail in a financial system.

This is due to the fact that supervision is not a full-proof shield against bank/NBFI failures. It must be construed that regulation and supervision are tools geared towards prevention of such failures, which may cost the government and public heavily if it happens. But, certainly not an end in itself to completely stop bank failures.

How is a liquidity problem distinct from insolvency?
To exacerbate the problem with credit risk, banks are also naturally prone to liquidity risk. This is so, because the liabilities of banks are often relatively short-term in nature and the assets relatively invested in longer term. In other words, banks often obtain funding from depositors that can be withdrawn within days or months, but they lend to businesses and households who can only repay the loans over many years. Fortunately, deposits are "rolled over" all the time, and banks can usually manage liquidity quite well. They are also required to hold a certain amount of their assets in liquid assets that can be quickly turned into cash. Un-seemingly, it sometimes happens that a negative sentiment about a bank can cause many depositors to withdraw at once, which can cause a liquidity problem. This is not as serious as a solvency problem, where losses have wiped out capital and liabilities exceed assets. In the case of a liquidity squeeze at a clearly solvent bank, there are often many ways to avert the problem. These can include private sector involvement, for example the selling of good loan assets to other banks, or in particular circumstances special liquidity assistance by the lender of last resort or by the government.

When and how do the regulatory authorities intervene to assist banks/NBFIs in distress?
The bank supervisor relies on several sources of information about impending problems at banks or NBFIs. At the first sign of trouble well-established procedures are put in place to resolve the problems. These may include re-structuring of activities, changes in management, and re-capitalisation by shareholders. Unfortunately, in certain cases the problems that the financial institutions face could be so severe that they simply cannot be resolved in terms of normal business principles. For instance, the bank made a strategic error in pursuing a particular market niche, and technological developments have resulted in it being marginalised. In such cases, it is in the best interest of depositors for such a bank to be liquidated and removed from the banking system in an orderly fashion.

When and how do the authorities intervene to assist banks in distress?
The bank supervisor relies on several sources of information about impending problems at banks. At the first sign of trouble well-established procedures are put in place to resolve the problems. These may include re-structuring of activities, changes in management, and re-capitalisation by shareholders. Unfortunately, in some cases the problems that the bank faces are so severe that they simply cannot be resolved in terms of normal business principles. For instance, the bank made a strategic error in pursuing a particular market niche, and technological developments have resulted in it being marginalised. In such cases it is in the best interest of depositors for such a bank to be liquidated and removed from the banking system in an orderly fashion.

What is Lender of Last Resort (LOLR) assistance and when is it applicable?
In some cases the underlying causes of a bank's problems can be sustainably resolved, and the only remaining issue is a short-term liquidity problem. In such cases the RMA may provide special short-term liquidity assistance, also known as lender of last resort assistance (LOLR). There are particular prescribed circumstances and conditions under which special liquidity assistance can be provided. Such assistance could be expensive to the bank being assisted, because the central bank needs to create a disincentive for its use.

What can be done to prevent harm to depositors when banks fail?
The most difficult part for the authorities is to structure and time their intervention in such a way that, although shareholders may lose their risk capital, depositors are fully reimbursed. A key mechanism to aid with this is the curator mechanism. The appointment of a curator to a bank is a way to ensure that the actions to protect depositors take place in an orderly, controlled and equitable way. The curator has legal powers to implement actions in the interest of all depositors, which the management of the bank does not have. For instance, if there is a run on a bank, depositors that are unable to drop everything and rush to the bank may be disadvantaged, yet the management, unlike the curator, cannot refuse to pay out the early withdrawals.

How does curator-ship work?
The first thing that happens is that the curator takes over the management of the bank, freezes all deposits, and suspends certain other activities. The curator's team (comprising some outside experts but mainly existing bank staff who are considered to be key to the achievement of the task of the curator) then analyses the liquidity position of the bank and determines a threshold up to which the bank can immediately pay every depositor. The threshold and procedures to conduct withdrawals are usually announced within a few days. In most cases the large majority of deposits are below the threshold, and can be fully paid out within days. Depositors with larger balances may be allowed to access only up to the threshold, and may have to wait until the task of the curator is completed for the rest. The curator, then proceeds to analyze the business of the bank and endeavors to either re-position it as a viable concern, or obtain the best possible deal in the interest of the depositors. While it is conceivable that the bank can be saved, or a buyer for the whole bank can be found, this is unlikely, as in such a case it would have been sold in the market place long before curator-ship. Often the bank is unbundled, and different parts of its business are sold to different banks. Sometimes a "scheme of arrangement" is conceived whereby depositors and creditors agree to a settlement of some kind. While these negotiations with potential buyers are proceeding, the curator's team tries to terminate as much as possible of the leases and other cost commitments of the bank, and generally winds down operations. If the bank or any part of it cannot be sold or re-positioned as a viable concern, the curator makes a recommendation to the Registrar that the remaining parts of the bank must be liquidated. A liquidator is appointed, who proceeds to liquidate all assets, unfortunately often at prices below their real worth, and finally pays all remaining depositors a pro rata amount.Unless the bank was either in reality deeply insolvent, or something caused its assets to lose value rapidly, the depositors will ultimately be fully, or almost fully, repaid. Other creditors will then be paid, and the bank deregistered and terminated. Unfortunately, depending on circumstances, this entire process can take more than a year.

Why can clients of banks not be warned in advance of impending problems?
Sometimes the event that causes a run is so sudden and unexpected that the authorities do not have a clear understanding of the problem. In some ways the curator-ship is an opportunity to stabilize the situation so that the true circumstances can be assessed and plans developed to resolve the problem. But normally the authorities have advance warning about problems at a bank. The first objective is always to find a sustainable resolution to the problem long before it threatens depositor funds. The process of analyzing the issues and developing plans to resolve the problems in a sustainable manner carries on while the bank continues with normal business. Often the situation deteriorates further before the changes made start taking effect. If the authorities where to communicate with depositors about their concerns with the bank it would not only detract from their efforts to find a solution, but also possibly precipitate the very thing that they are working to avoid, namely a run on the bank. It is therefore standard practice for regulators worldwide to refrain from ever commenting on the affairs of a bank. A regulator would normally only confirm the licensed status of a bank, which implies that it is still in compliance with the regulatory prudential requirements.

What is deposit insurance?
A deposit insurance scheme involves the collection of a small premium from depositors to protect them from losses arising from the closure of a bank. Deposit insurance can distort the risk-reward decision-making process and therefore the effectiveness of market discipline to ensure that banks are well managed. As a result, it is almost always aimed at protecting only small depositors up to a certain amount. Provided it is well funded and can pay small depositors quickly and efficiently, a deposit insurance scheme can be of great value in improving confidence and in reducing hardship in case of bank failure. It should be remembered, however, that large institutional depositors are still expected to assess the risks of depositing with banks, and the better they do their jobs, the sooner they will be to withdraw their deposits from banks at the first sign of trouble. A deposit insurance scheme will therefore not necessarily avert a run on a bank or prevent curator-ship. It does have the advantage that it makes the process of paying back small depositors so much more orderly, equitable and transparent.

Will problems in one bank affect other banks?
It is quite often assumed that problems in one large bank will automatically spillover to other banks and endanger the system. This is a fallacy, as there is no empirical evidence to support this. In all banking crises in recent times, the problems became systemic only where other banks were all exposed to more or less the same extraneous risk, for example a rapid asset price decline, a massive capital outflow, or a sharp commodity price change.

The risk profile of spillover effects within a financial system could be high under situation, where there are inter-linkages of cross-shareholdings or relative over dependence amongst financial institutions.